By Yolande Knell BBC News, Jerusalem
The European Commission is being urged to consider drafting legislation to ensure financial transactions by EU member states do not support Jewish settlements in East Jerusalem.
The proposal is made in a confidential report by top EU diplomats in the area.
The report says "the systematic increase in settlement activity" undermines a two-state solution to the Israel-Palestinian conflict.
It also describes a "deteriorating situation on the ground".
The EU Heads of Mission Report on East Jerusalem, which was sent to Brussels this week and was leaked to the BBC, builds on earlier reports that also criticised Israeli policies.
In a long list of recommendations, it suggests that the Commission proposes "appropriate EU legislation to prevent/discourage financial transactions in support of settlement activity".
Settlements are considered illegal under international law although Israel disputes this.
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"The EU treats these serial reports in the best possible way - they are discussed briefly, their absurd recommendations are disregarded and the reports are quickly shelved”
Yigal Palmor Israeli Foreign Ministry spokesman
The EU document argues that Israel is "actively perpetuating its annexation" of Arab East Jerusalem, which it captured in 1967, by "systematically undermining the Palestinian presence in the city".
It outlines the problems caused by "the continued expansion of settlements, restrictive zoning and planning, ongoing demolitions and evictions, an inequitable education policy, difficult access to health care, the inadequate provision of resources and investment and the precarious residency issue".
The Palestinians want East Jerusalem to be the capital of a future state, but Israel is determined that Jerusalem be its undivided capital.
'Facts on the ground'
Palestinian officials are reluctant to respond to the report because it has not been published.
However, speaking on condition of anonymity one told the BBC: "We think it shows facts on the ground that nobody can dispute. We now expect European capitals to implement the recommendations."
The Israeli foreign ministry's spokesman, Yigal Palmor, said there had been no consultation with Israel on the subject and that it was "therefore the result of an extremely dubious methodology".
"The EU treats these serial reports in the best possible way - they are discussed briefly, their absurd recommendations are disregarded and the reports are quickly shelved," he added.
This document follows a number of strongly-worded European statements and reports that have come to light in recent days.
On Monday, the UK's Deputy Prime Minister, Nick Clegg, condemned settlements as "an act of deliberate vandalism to the basic premise upon which negotiations have taken place for years".
Israel's Deputy Foreign Minister, Danny Ayalon, who is visiting the UK, described Mr Clegg's comments as "ill-informed" and "irresponsible", saying they gave the Palestinians an excuse to set pre-conditions on negotiations with Israel on a peace settlement.
An internal EU report leaked last week was very critical of Israel's policies and planning rules in "Area C", the 62% of the West Bank which it fully controls.
A French parliamentary report also described Israel's water policies in the occupied Palestinian territories as a form of "apartheid", because they give preferential treatment to Jewish settlers. The comments were welcomed by the head of the Palestinian Water Authority.
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